Sooner or later nearly everyone will be affected – infected, shall we say? – by "bracket creep." Ryan L. Ellis, dubbed "the high priest of Republican tax-cutting," by The New York Times, bemoans bracket creep.
In an interview with ThinkAdvisor, Ellis, a leading tax expert on the political scene and an IRS enrolled agent shed light on bracket creep and other matters germane to 2015 tax returns and beyond.
The senior advisor for tax policy to the Conservative Reform Network spends the bulk of his time trying to persuade companies to work better with conservative groups. He is also a Washington lobbyist on tax issues.
As an enrolled agent, Ellis's federal license authorizes him to represent taxpayers of any state. During the first three-and-a-half months of each year, he runs a tax preparation service, Ryan Ellis LLC, based in Arlington, Virginia, specializing in small-business and retail property returns.
He was formerly lead federal tax policy director of Grover Norquist's Americans for Tax Reform, an organization founded in the course of Ronald Reagan's presidency. Author of the book "Tax Reform for Our Century" (Conservative Reform Network), Ellis makes the case for revamping the tax code as a way to generate economic growth and bring tax relief to working families with children.
ThinkAdvisor spoke with him about tax-efficient investments, this season's taxpayer surprises, what's upcoming for 2016 and why bracket creep is a damnable fact of life. Here are interview highlights:
THINKADVISOR: Is the U.S. tax system becoming increasingly progressive?
RYAN L. ELLIS: Yes. It has built into it things that make it more and more progressive every year. That increases the tax burden every year. So it's already baked into the cake: If we keep current law in place, we're going to have higher taxes and more progressive taxes. The Congressional Budget Office says that by the end of this century, the federal tax burden will go from the current 18% of GDP to 24% of GDP, which will be a record.
Why?
Two reasons: The first is bracket creep, which happens because the tax brackets are indexed to inflation. The CBO is projecting that more and more income will be taxed at higher bracket levels because people's incomes grow faster than inflation, and that's especially true at the top end.
What's the second reason?
The 3.8% surtax on savings and investments – a result of Obamacare – is not indexed to inflation: It kicks in with households that have adjusted gross income of $250,000 or more. Over time, more people will be making $250,000. In a hundred years, that will be what you earn if you work at McDonald's during the week! So almost everybody is going to be paying that 3.8%. Any surprises for taxpayers this year?
A few. One is how high capital gains rates have become. People still have 15% in their heads because that was the rate for about 10 years. But if you're a high net worth individual, you can easily have the regular capital gains rate of 20% and on top of that the 3.8% surtax. With itemized deductions being clawed back, this has the mathematical effect of increasing the capital gains rate. And then, state income taxes have been on the rise for the last 10 to 15 years.
What might be the grand total?
When you calculate the entire amount, you could find yourself with a 30% to 35% capital gains rate. That's much higher than it was even five or six years ago.
Any other surprises?
If you're making $150,000 to about $600,000, you're likely an Alternative Minimum Tax household. AMT is a certain set of [complex] tax calculations that you have to live under. Everyone thinks this has been repealed. It's not gone.
Any more surprises?
Because the 3.8% surtax isn't indexed to inflation, every year more and more households will find themselves in that surtax area. They'll have a capital gains rate and [surtax] of 23.8%, and for the most part, ordinary income tax rates in the 40%'s, if they're at the high end.
The Bush tax cuts expired at the end of 2012. So is that issue no longer relevant?
All the Bush tax cuts went away permanently for about 12 to 18 hours. But then Congress passed a piece of legislation, the American Tax Relief Act, or ATRA. What that did was to permanently put in place Bush tax-cut levels for households making less than $250,000 a year. For those making more than that, the Bush tax-cut provisions mostly expired.
Any notable exceptions?
Under ATRA, qualified dividends are permanently taxed at the same rate as long-term capital gains – the way they have been since 2003. Before 2003, they were taxed as ordinary income.
What's another exception?
The 39.6% tax bracket was restored but in a way that there's only a $2,000 income differential between it and the 35% bracket. This is a very odd situation: the top two brackets – 35% and 39.6% – are almost exactly the same. This was done artificially as a result of political compromise. So you have a couple of little odd cats and dogs at the higher end.
What's important to know for investors who own company stock?
This is something that advisors should keep in mind: If you're a high-net-worth individual living in a higher-tax state and keep [company stock] in a brokerage account, when it throws off dividends, you could very easily find yourself paying a 30% or 35% combined annual tax. [Hence], by putting that stock in a brokerage account, over time, taxes will eat away the ability to grow those assets. [Meanwhile], dividends could have grown tax deferred – and maybe get reinvested – if the [stock] were inside a qualified plan or an IRA. What impact do low oil prices have on the taxes of master limited partnership (MLP) investors?
The first issue with energy-derived MLPs is that plummeting oil prices means there will probably be less of a profit-share allocation to you as a partner. The other is that the permanent tax bill that was passed [stipulates] scrutiny of partnership returns. So there's an increased audit risk at the partnership level to make sure the tax liability that's implied on the partnership tax return actually finds its way down to the [Schedule] K1.
